Whether you’re on forums, Reddit, Twitter (X), or even Threads, you will see chatter about covered call ETFs. They’re incredibly popular with dividend and fixed income investors, especially within the FIRE (financially independent, retire early) movement.
Some of the most popular covered call ETFs include:
- JEPI: JPMorgan Equity Premium Income ETF
- JEPQ: JPMorgan Equity Premium Plus ETF
- QYLD: Global X NASDAQ-100 Covered Call ETF
- RYLD: Global X Russell 2000 Covered Call ETF
- XYLD: Global X S&P 500 Covered Call ETF
What Are Covered Calls?
A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. The strategy is typically used to generate additional income from a portfolio by selling options against securities already owned.
A covered call ETF (Exchange Traded Fund) uses this strategy to generate income from the underlying assets of the ETF. The ETF will own a basket of stocks and then sell call options on those stocks. The premium received from selling these options can be distributed to the ETF shareholders, often resulting in a higher yield than the underlying assets would produce on their own.
The trade off here is that investors can miss out on potential upside during a bull market. There are pros and cons to owning covered call ETFs, but we’re going to dive into tax implications.
The Tax Side of Covered Call ETFs
While covered call ETFs can provide attractive income, understanding their tax implications is vital. Why? Because the taxes you pay can eat into your returns. So, let’s dive into the tax side of things!
How Covered Call Income is Taxed
When you receive income from a covered call ETF, it’s typically considered ordinary income, not qualified dividend income (see SCHD for a dividend ETF with qualified dividend income). This means you’re taxed at your regular income tax rate, not the lower qualified dividend rate. For investors in higher tax brackets, this can make a difference!
Short-term vs. Long-term Capital Gains
Another tax aspect to consider is capital gains. When a covered call is exercised and the underlying stock is sold, it could generate capital gains. If the ETF held the stock for over a year, it’s a long-term gain (taxed at a lower rate). But if held for less, it’s short-term (taxed at your regular income rate).
Tax Advantage of Holding in Tax-Deferred Accounts
Considering the tax implications, it might make sense to hold covered call ETFs in tax-advantaged accounts like IRAs or 401(k)s. Here’s why:
- No Immediate Tax on Distributions: In traditional IRAs or 401(k)s, you won’t pay taxes on the income or capital gains from your covered call ETFs until you start taking distributions.
- Roth Advantage: If held in a Roth IRA, the distributions could be entirely tax-free if taken after age 59½ and the account is at least five years old.
- Avoiding Tax Complications: Managing taxes with covered call ETFs can get complicated. Holding them in a tax-advantaged account simplifies things.
When It Might NOT Make Sense to Use Tax-Advantaged Accounts
While tax-advantaged accounts sound perfect, there are scenarios where it might not be ideal:
- Liquidity Needs: If you might need access to the funds before retirement age, pulling them out of a 401(k) or IRA might lead to penalties.
- Mandatory Distributions: Traditional IRAs have required minimum distributions (RMDs) once you hit a certain age. If you don’t need the money, these mandatory withdrawals might be inconvenient.
Conclusion: Weighing the Tax Trade-offs
Covered call ETFs offer a unique blend of income and potential for capital appreciation. But like all investments, they come with tax considerations. By understanding these tax implications and strategically deciding where to hold these ETFs, you can potentially optimize your after-tax returns. Always remember, when it comes to taxes, consulting with a tax professional can provide tailored advice to your situation.
